1. MACROECONOMICS © 2014 Worth Publishers, all rights reserved N. Gregory Mankiw PowerPoint ® Slides by Ron Cronovich Fall 2013 update Aggregate Demand II: Applying the IS - LM Model 12

2. 1 CHAPTER 12 Aggregate Demand II Context  Chapter 10 introduced the model of aggregate demand and supply.  Chapter 11 developed the IS-LM model, the basis of the aggregate demand curve.

3. IN THIS CHAPTER, YOU WILL LEARN:  how to use the IS-LM model to analyze the effects of shocks, fiscal policy, and monetary policy  how to derive the aggregate demand curve from the IS-LM model  several theories about what caused the Great Depression 2

4. 3 CHAPTER 12 Aggregate Demand II The intersection determines the unique combination of Y and r that satisfies equilibrium in both markets. The LM curve represents money market equilibrium. Equilibrium in the IS -LM model The IS curve represents equilibrium in the goods market. IS Y r LM r1r1 Y1Y1

5. 4 CHAPTER 12 Aggregate Demand II Policy analysis with the IS -LM model We can use the IS-LM model to analyze the effects of fiscal policy: G and/or T monetary policy: M IS Y r LM r1r1 Y1Y1

6. 5 CHAPTER 12 Aggregate Demand II causing output & income to rise. IS 1 An increase in government purchases 1. IS curve shifts right Y r LM r1r1 Y1Y1 IS 2 Y2Y2 r2r2 1. 2. This raises money demand, causing the interest rate to rise… 2. 3. …which reduces investment, so the final increase in Y 3.

7. 6 CHAPTER 12 Aggregate Demand II IS 1 1. A tax cut Y r LM r1r1 Y1Y1 IS 2 Y2Y2 r2r2 Consumers save (1  MPC) of the tax cut, so the initial boost in spending is smaller for  T than for an equal  G… and the IS curve shifts by 1. 2. …so the effects on r and Y are smaller for  T than for an equal  G. 2.

8. 7 CHAPTER 12 Aggregate Demand II 2.…causing the interest rate to fall IS Monetary policy: An increase in M 1.  M > 0 shifts the LM curve down (or to the right) Y r LM 1 r1r1 Y1Y1 Y2Y2 r2r2 LM 2 3.…which increases investment, causing output & income to rise.

9. 8 CHAPTER 12 Aggregate Demand II Interaction between monetary & fiscal policy  Model:  Monetary & fiscal policy variables (M, G, and T ) are exogenous.  Real world:  Monetary policymakers may adjust M in response to changes in fiscal policy, or vice versa.  Such interactions may alter the impact of the original policy change.

10. 9 CHAPTER 12 Aggregate Demand II The Fed’s response to  G > 0  Suppose Congress increases G.  Possible Fed responses: 1. hold M constant 2. hold r constant 3. hold Y constant  In each case, the effects of the  G are different…

11. 10 CHAPTER 12 Aggregate Demand II If Congress raises G, the IS curve shifts right. IS 1 Response 1: Hold M constant Y r LM 1 r1r1 Y1Y1 IS 2 Y2Y2 r2r2 If Fed holds M constant, then LM curve doesn’t shift. Results:

12. 11 CHAPTER 12 Aggregate Demand II If Congress raises G, the IS curve shifts right. IS 1 Response 2: Hold r constant Y r LM 1 r1r1 Y1Y1 IS 2 Y2Y2 r2r2 To keep r constant, Fed increases M to shift LM curve right. LM 2 Y3Y3 Results:

13. 12 CHAPTER 12 Aggregate Demand II IS 1 Response 3: Hold Y constant Y r LM 1 r1r1 IS 2 Y2Y2 r2r2 To keep Y constant, Fed reduces M to shift LM curve left. LM 2 Results: Y1Y1 r3r3 If Congress raises G, the IS curve shifts right.

14. 13 CHAPTER 12 Aggregate Demand II Estimates of fiscal policy multipliers from the DRI macroeconometric model Assumption about monetary policy Estimated value of  Y /  G Fed holds nominal interest rate constant Fed holds money supply constant 1.93 0.60 Estimated value of  Y /  T  1.19  0.26

15. 14 CHAPTER 12 Aggregate Demand II Shocks in the IS -LM model IS shocks: exogenous changes in the demand for goods & services. Examples:  stock market boom or crash  change in households’ wealth   C  change in business or consumer confidence or expectations   I and/or  C

16. 15 CHAPTER 12 Aggregate Demand II Shocks in the IS -LM model LM shocks: exogenous changes in the demand for money. Examples:  A wave of credit card fraud increases demand for money.  More ATMs or the Internet reduce money demand.

17. Analyze shocks with the IS-LM model NOW YOU TRY Analyze shocks with the IS-LM model Use the IS-LM model to analyze the effects of 1.a housing market crash that reduces consumers’ wealth 2.consumers using cash in transactions more frequently in response to an increase in identity theft For each shock, a. use the IS-LM diagram to determine the effects on Y and r. b. figure out what happens to C, I, and the unemployment rate. 16

18. Housing market crash ANSWERS, PART 1 Housing market crash 17 IS 1 Y r LM 1 r1r1 Y1Y1 IS 2 Y2Y2 r2r2 IS shifts left, causing r and Y to fall. C falls due to lower wealth and lower income, I rises because r is lower u rises because Y is lower (Okun’s law)

19. Increase in money demand ANSWERS, PART 2 Increase in money demand 18 IS 1 Y r LM 1 r1r1 Y1Y1 Y2Y2 r2r2 LM 2 LM shifts left, causing r to rise and Y to fall. C falls due to lower income, I falls because r is higher u rises because Y is lower (Okun’s law)

20. 19 CHAPTER 12 Aggregate Demand II CASE STUDY: The U.S. recession of 2001  During 2001:  2.1 million jobs lost, unemployment rose from 3.9% to 5.8%.  GDP growth slowed to 0.8% (compared to 3.9% average annual growth during 1994–2000).

21. 20 CHAPTER 12 Aggregate Demand II CASE STUDY: The U.S. recession of 2001 Causes: 1) Stock market decline   C 300 600 900 1,200 1,500 199519961997199819992000200120022003 Index (1942 = 100) Standard & Poor’s 500

22. 21 CHAPTER 12 Aggregate Demand II CASE STUDY: The U.S. recession of 2001 Causes: 2) 9/11  increased uncertainty  fall in consumer & business confidence  result: lower spending, IS curve shifted left Causes: 3) Corporate accounting scandals  Enron, WorldCom, etc.  reduced stock prices, discouraged investment

23. 22 CHAPTER 12 Aggregate Demand II CASE STUDY: The U.S. recession of 2001 Fiscal policy response: shifted IS curve right  tax cuts in 2001 and 2003  spending increases  airline industry bailout  NYC reconstruction  Afghanistan war

24. 23 CHAPTER 12 Aggregate Demand II CASE STUDY: The U.S. recession of 2001 Monetary policy response: shifted LM curve right Three-month T-Bill rate 0 1 2 3 4 5 6 7 01/01/200004/02/2000 07/03/200010/03/2000 01/03/200104/05/200107/06/200110/06/200101/06/200204/08/200207/09/2002 10/09/2002 01/09/200304/11/2003

25. 24 CHAPTER 12 Aggregate Demand II What is the Fed’s policy instrument?  The news media commonly report the Fed’s policy changes as interest rate changes, as if the Fed has direct control over market interest rates.  In fact, the Fed targets the federal funds rate—the interest rate banks charge one another on overnight loans.  The Fed changes the money supply and shifts the LM curve to achieve its target.  Other short-term rates typically move with the federal funds rate.

26. 25 CHAPTER 12 Aggregate Demand II What is the Fed’s policy instrument? Why does the Fed target interest rates instead of the money supply? 1) They are easier to measure than the money supply. 2) The Fed might believe that LM shocks are more prevalent than IS shocks. If so, then targeting the interest rate stabilizes income better than targeting the money supply. (See problem 7 on p.353.)

27. 26 CHAPTER 12 Aggregate Demand II IS-LM and aggregate demand  So far, we’ve been using the IS-LM model to analyze the short run, when the price level is assumed fixed.  However, a change in P would shift LM and therefore affect Y.  The aggregate demand curve (introduced in Chap. 10) captures this relationship between P and Y.

28. 27 CHAPTER 12 Aggregate Demand II Y1Y1 Y2Y2 Deriving the AD curve Y r Y P IS LM(P 1 ) LM(P 2 ) AD P1P1 P2P2 Y2Y2 Y1Y1 r2r2 r1r1 Intuition for slope of AD curve:  P   (M/P )  LM shifts left  r r  I I  Y Y

29. 28 CHAPTER 12 Aggregate Demand II Monetary policy and the AD curve Y P IS LM(M 2 /P 1 ) LM(M 1 /P 1 ) AD 1 P1P1 Y1Y1 Y1Y1 Y2Y2 Y2Y2 r1r1 r2r2 The Fed can increase aggregate demand:  M  LM shifts right AD 2 Y r  r r  I I   Y at each value of P

30. 29 CHAPTER 12 Aggregate Demand II Y2Y2 Y2Y2 r2r2 Y1Y1 Y1Y1 r1r1 Fiscal policy and the AD curve Y r Y P IS 1 LM AD 1 P1P1 Expansionary fiscal policy (  G and/or  T ) increases agg. demand:  T   C  IS shifts right   Y at each value of P AD 2 IS 2

31. 30 CHAPTER 12 Aggregate Demand II IS-LM and AD-AS in the short run & long run Recall from Chapter 10: The force that moves the economy from the short run to the long run is the gradual adjustment of prices. rise fall remain constant In the short-run equilibrium, if then over time, the price level will

32. 31 CHAPTER 12 Aggregate Demand II The SR and LR effects of an IS shock A negative IS shock shifts IS and AD left, causing Y to fall. Y r Y P LRAS IS 1 SRAS 1 P1P1 LM(P 1 ) IS 2 AD 2 AD 1

33. 32 CHAPTER 12 Aggregate Demand II The SR and LR effects of an IS shock Y r Y P LRAS IS 1 SRAS 1 P1P1 LM(P 1 ) IS 2 AD 2 AD 1 In the new short-run equilibrium,

34. 33 CHAPTER 12 Aggregate Demand II The SR and LR effects of an IS shock Y r Y P LRAS IS 1 SRAS 1 P1P1 LM(P 1 ) IS 2 AD 2 AD 1 In the new short-run equilibrium, Over time, P gradually falls, causing: SRAS to move down M/P to increase, which causes LM to move down Over time, P gradually falls, causing: SRAS to move down M/P to increase, which causes LM to move down

35. 34 CHAPTER 12 Aggregate Demand II AD 2 The SR and LR effects of an IS shock Y r Y P LRAS IS 1 SRAS 1 P1P1 LM(P 1 ) IS 2 AD 1 SRAS 2 P2P2 LM(P 2 ) Over time, P gradually falls, causing: SRAS to move down M/P to increase, which causes LM to move down Over time, P gradually falls, causing: SRAS to move down M/P to increase, which causes LM to move down

36. 35 CHAPTER 12 Aggregate Demand II AD 2 SRAS 2 P2P2 LM(P 2 ) The SR and LR effects of an IS shock Y r Y P LRAS IS 1 SRAS 1 P1P1 LM(P 1 ) IS 2 AD 1 This process continues until economy reaches a long-run equilibrium with

37. Analyze SR & LR effects of  M NOW YOU TRY Analyze SR & LR effects of  M 36 a. Draw the IS-LM and AD-AS diagrams as shown here. b. Suppose Fed increases M. Show the short-run effects on your graphs. c. Show what happens in the transition from the short run to the long run. d. How do the new long-run equilibrium values of the endogenous variables compare to their initial values? Y r Y P LRAS IS SRAS 1 P1P1 LM( M 1 /P 1 ) AD 1

38. Short-run effects of  M ANSWERS, PART 1 Short-run effects of  M 37 LM and AD shift right. r falls, Y rises above Y r Y P LRAS IS SRAS P1P1 LM( M 1 /P 1 ) AD 1 LM( M 2 /P 1 ) AD 2 Y2Y2 Y2Y2 r2r2 r1r1

39. Transition from short run to long run ANSWERS, PART 2 Transition from short run to long run 38 Over time,  P rises  SRAS moves upward  M/P falls  LM moves leftward New long-run eq’m  P higher  all real variables back at their initial values Money is neutral in the long run. Y r Y P LRAS IS SRAS P1P1 LM( M 1 /P 1 ) AD 1 LM( M 2 /P 1 ) AD 2 Y2Y2 Y2Y2 r2r2 r1r1 LM( M 2 /P 3 ) SRAS P3P3 r3 =r3 =

40. The Great Depression Unemployment (right scale) Real GNP (left scale) 120 140 160 180 200 220 240 192919311933193519371939 billions of 1958 dollars 0 5 10 15 20 25 30 percent of labor force

41. 40 CHAPTER 12 Aggregate Demand II THE SPENDING HYPOTHESIS: Shocks to the IS curve  Asserts the Depression was largely due to an exogenous fall in the demand for goods & services—a leftward shift of the IS curve.  Evidence: output and interest rates both fell, which is what a leftward IS shift would cause.

42. 41 CHAPTER 12 Aggregate Demand II THE SPENDING HYPOTHESIS: Reasons for the IS shift  Stock market crash  exogenous  C  Oct 1929–Dec 1929: S&P 500 fell 17%  Oct 1929–Dec 1933: S&P 500 fell 71%  Drop in investment  Correction after overbuilding in the 1920s.  Widespread bank failures made it harder to obtain financing for investment.  Contractionary fiscal policy  Politicians raised tax rates and cut spending to combat increasing deficits.

43. 42 CHAPTER 12 Aggregate Demand II THE MONEY HYPOTHESIS: A shock to the LM curve  Asserts that the Depression was largely due to huge fall in the money supply.  Evidence: M1 fell 25% during 1929–33.  But, two problems with this hypothesis:  P fell even more, so M/P actually rose slightly during 1929–31.  nominal interest rates fell, which is the opposite of what a leftward LM shift would cause.

44. 43 CHAPTER 12 Aggregate Demand II THE MONEY HYPOTHESIS AGAIN: The effects of falling prices  Asserts that the severity of the Depression was due to a huge deflation: P fell 25% during 1929–33.  This deflation was probably caused by the fall in M, so perhaps money played an important role after all.  In what ways does a deflation affect the economy?

45. 44 CHAPTER 12 Aggregate Demand II THE MONEY HYPOTHESIS AGAIN: The effects of falling prices  The stabilizing effects of deflation:   P   (M/P )  LM shifts right   Y  Pigou effect: P  (M/P )P  (M/P )  consumers’ wealth   C C  IS shifts right  Y Y

46. 45 CHAPTER 12 Aggregate Demand II THE MONEY HYPOTHESIS AGAIN: The effects of falling prices  The destabilizing effects of expected deflation:  E   r  for each value of i  I  because I = I (r )  planned expenditure & agg. demand   income & output 

47. 46 CHAPTER 12 Aggregate Demand II THE MONEY HYPOTHESIS AGAIN: The effects of falling prices  The destabilizing effects of unexpected deflation: debt-deflation theory  P (if unexpected)  transfers purchasing power from borrowers to lenders  borrowers spend less, lenders spend more  if borrowers’ propensity to spend is larger than lenders’, then aggregate spending falls, the IS curve shifts left, and Y falls

48. 47 CHAPTER 12 Aggregate Demand II Why another Depression is unlikely  Policymakers (or their advisers) now know much more about macroeconomics:  The Fed knows better than to let M fall so much, especially during a contraction.  Fiscal policymakers know better than to raise taxes or cut spending during a contraction.  Federal deposit insurance makes widespread bank failures very unlikely.  Automatic stabilizers make fiscal policy expansionary during an economic downturn.

49. 48 CHAPTER 12 Aggregate Demand II CASE STUDY The 2008–09 financial crisis & recession  2009: Real GDP fell, u-rate approached 10%  Important factors in the crisis:  early 2000s Federal Reserve interest rate policy  subprime mortgage crisis  bursting of house price bubble, rising foreclosure rates  falling stock prices  failing financial institutions  declining consumer confidence, drop in spending on consumer durables and investment goods

50. Interest rates and house prices

51. Change in U.S. house price index and rate of new foreclosures, 1999–2009

52. House price change and new foreclosures, 2006:Q3–2009:Q1 New foreclosures, % of all mortgages Cumulative change in house price index Nevada Georgia Colorado Texas Alaska Wyoming Arizona California Florida S. Dakota Illinois Michigan Rhode Island N. Dakota Oregon Ohio New Jersey Hawaii

53. U.S. bank failures by year, 2000–2011

54. Major U.S. stock indexes (% change from 52 weeks earlier)

55. Consumer sentiment and growth in consumer durables and investment spending

56. Real GDP growth and unemployment

57. CHAPTER SUMMARY 1. IS-LM model  a theory of aggregate demand  exogenous: M, G, T, P exogenous in short run, Y in long run  endogenous: r, Y endogenous in short run, P in long run  IS curve: goods market equilibrium  LM curve: money market equilibrium 56

58. CHAPTER SUMMARY 2. AD curve  shows relation between P and the IS-LM model’s equilibrium Y.  negative slope because  P   (M/P )   r   I   Y  expansionary fiscal policy shifts IS curve right, raises income, and shifts AD curve right.  expansionary monetary policy shifts LM curve right, raises income, and shifts AD curve right.  IS or LM shocks shift the AD curve. 57